What if most of the public employee compensation enhancements of the past decade or more in California were based on inaccurately optimistic government financial statements? Or to be blunt, what if government decision makers incorrectly thought they could afford these compensation enhancements because the information they relied on used accounting gimmicks that would land a person in private industry in jail for fraud?

In February the California Public Policy Center (CPPC) published “How Lower Earnings Will Impact California’s Total Unfunded Pension Liability,” where, using various rates of annual investment earnings, the number ranged between $128 billion and $576 billion. This study and others highlighted that starting in 2014, not only will Moody’s Investors Services begin using a much lower investment projection in their credit analysis, but GASB—the Government Accounting Standards Board—will require government entities to recognize this liability on their balance sheets.

The CPPC recently published a new study, “Unmasking Staggering Pension Debt and Hidden Expense,” which considered seven California counties—Alameda, Contra Costa, Marin, Mendocino, Orange, San Mateo, and Sonoma—and restated their balance sheets based on the new GASB financial reporting standards and the new Moody’s credit evaluation criteria. In his analysis of these seven California counties, researcher John Dickerson calculated the new GASB rules will lower their combined net worth by a factor of 10, from a current reported $10.2 billion to less than $1.0 billion. And all of these losses, in any private enterprise, already would have been recognized.

Billions in Expenses Unreported

Starting in 2014, GASB will require state and local governments to report their unfunded pension obligations as a liability on their balance sheets, eliminating a loophole in their current regulations. The loopholes being plugged by GASB Statement No. 68 have permitted California’s cities and counties to declare balanced budgets when in fact they were failing to report billions in pension expense.

In addition to calculating the impact of GASB 68, the study estimates the impact of GASB’s new rule combined with Moody’s new credit evaluation criteria on government financial statements.

Dickerson writes, “These seven counties all together would drop from $10.2 billion of Net Assets down to a negative $8.3 billion hole—$19 billion less. On average, they would have more unfunded pension debt than assets.”

One may argue whether Moody’s 5.5 percent discount rate is too low, so let’s accept for the moment the long-term pension earnings projection of 7.5 percent per year as realistic. This still means the seven counties analyzed failed to report more than $10.2 billion in liabilities. And it still means across all of California, the state and local governments failed to report more than $128 billion in liabilities, because $128 billion is the State Controller’s officially acknowledged amount of unfunded pension liabilities.

Most Net Worth Erased

For the last decade or more, as cities and counties were negotiating enhancements to public employee pension plans, and other compensation enhancements—sometimes in council meetings packed with indignant public workers, other times in binding arbitration—they were basing their decisions on inaccurate financial statements. Would pension formulas have been increased from 2.5 percent at age 55 to 3.0 percent at age 50, for example, if everyone at the negotiating table had been examining city or county financial statements that correctly recorded these billions in losses?

No business can long survive with bad financial information. Any auditor who’s picked apart a few balance sheets, or any general ledger accountant who’s closed a few fiscal years, understands how easy it is to commit fraud. If bankers and investors are wary of a company’s financial performance and need to see more profit, an unscrupulous entrepreneur might revalue inventory to “market value,” and voila, a loss turns into a profit. What GASB 68 is going to prevent might excite only an accountant, but because its consequences affect us all, it’s still a story worth trying to tell.

Municipalities Acted Mendaciously

When many of California’s cities and counties fell behind in their payments to the pension funds, they didn’t record a payable on their balance sheet—because GASB didn’t have a standard in place to force them to. When the time came to make the payment, they needed to borrow the money, but they didn’t want to ask voters to approve a pension obligation bond. So they essentially sued themselves, securing a court ruling that documented they owed the money.

This allowed them to characterize the pension obligation bond’s issuance as a refinancing of existing debt, avoiding the need to submit the bond to voters for approval.

Then (accounting wonks, pay attention here), when they put the pension obligation bond debt onto their balance sheet as a liability, because they had not recorded a preexisting payable to the pension fund, instead they put the debit onto the top of the balance sheet as an offsetting asset, which they are slowly amortizing. GASB 68 will wipe out all of this, creating billions in extraordinary losses that will mostly be declared in prior period adjustments of past financial statements.

This behavior violates fundamental accounting concepts, most particularly, matching expenses to the time they are incurred. But during the 1990s and since, it allowed cities and counties to avoid placing billions in losses on their income statements. That allowed public employee unions, politicians, and arbitrators, to make decisions based on flawed, overly optimistic financial information. And it enabled a legacy of contracted compensation increases that are considered by their supporters to be beyond even the power of a bankruptcy court to amend.

Ed Ring(editor@unionwatch.org)is editor of UnionWatch.org, a project of the California Public Policy Center. Used with permission of UnionWatch.org.